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Executive Compensation in Bankruptcy

October 2008 | Bankruptcy Protector

The recent downturn in the financial sector and related bankruptcy filings have shed light on issues involving executive compensation, particularly in chapter 11 cases. Specifically, bankrupt companies often have paid substantial bonuses to executives prior to filing for bankruptcy protection and desire to retain those executives throughout the bankruptcy process through additional bonus payments and similar schemes. These types of payments have been criticized as giveaways to management. Congress has attempted to resolve the matter by placing limitations on such payments, but debtors continue to find creative ways to make them with the approval of bankruptcy courts, arguing that the payments are necessary in order to keep qualified officers.

Executive Compensation and the 2005 Bankruptcy Act
Prior to the enactment of the Bankruptcy Abuse and Consumer Protection Act of 2005 (2005 Bankruptcy Act), debtors would routinely seek authority to implement payment plans for key personnel, typically including executives. These plans were often titled Key Employee Retention Plans (KERPs). KERPs often included: (i) retention payments to eligible employees through a particular date; (ii) bonuses paid upon confirmation of a reorganization plan or sale of the business; and (iii) severance payments. KERPs typically are designed to induce management to continue working for the struggling business rather than move to more financially stable competitors.

In the past, bankruptcy courts typically approved KERPs where the debtor exercised proper business judgment, established a sound business purpose and a plan that was fair and reasonable. These criteria allowed bankruptcy courts substantial discretion in approving these plans. Typically, the debtor would present evidence establishing that without the KERP, it risked losing the covered employees, and would, as a consequence, suffer a loss. In essence, the KERP was presented as a way to minimize the risk of loss.

Prior to the 2005 Bankruptcy Act, KERPs often provided more substantial bonuses to more senior executives. For example, in the Kmart bankruptcy case, the bankruptcy court approved a $150 million KERP, of which $2.5 million was to be paid to its Chief Executive Officer. In Enron, the company paid pre-petition bonuses of approximately $105 million, and received approval for KERP payments totaling over $100 million. WorldCom also received approval for $25 million in KERP payments.

As a result of the perceived excesses and insider greed contained within KERPs, Congress—through the 2005 Bankruptcy Act—included
§ 503(c) as a new provision in the Bankruptcy Code. This section contains limitations in the allowance or payment of amounts to "an insider of the debtor for the purpose of inducing such person to remain with the debtor's business" as well as limitations on severance payments and other payments to officers, managers or consultants that are outside of the ordinary course of business.

Executive Retention in Bankruptcy after 2005
Debtors and their counsel have continued to seek approval of plans designed to stem the exodus of talented managers. The key to these efforts is avoiding "pay to stay" retention plans in an effort to fall outside of the ambit of § 503(c)(1). Typically, and with varying success, debtors have formulated "incentive" plans rather than "retention" plans in order to obtain approval under the traditional "business judgment standard." Courts have rejected plans that only require the employee to remain on the job in order to receive payments, while approving plans that require certain performance standards and benchmarks.

Nobex Corporation may have been the first post-2005 Bankruptcy Act case to consider the impact of § 503(c) on these plans. In Nobex, the debtor sought to pay bonuses related to the sale of its assets to its acting Chief Executive Officer and Vice President of Finance. The debtor claimed that these individuals were the only people capable of guiding the debtor through a chapter 11 sale. Specifically, the Nobex plan provided for compensation if the gross sale price of the assets exceeded the initial stalking horse bid. The court found that the payments were not "retention bonuses" and accordingly found § 503(c) inapplicable. Other courts have approved incentive plans that included bonuses to insiders based on the value of the company upon emergence from bankruptcy and other performance goals.

However, bankruptcy judges continue to carefully examine plans providing for payments to executives. In Dana Corporation, the court rejected a bonus scheme that contemplated payment of bonuses to the debtor's Chief Executive Officer and other executives upon, among other things, the effective date of a reorganization plan and the total enterprise value of the debtor upon emergence. The plan also included potential payments upon termination for the execution of a noncompete agreement. The court ruled that the plan was an impermissible end-run around the requirements of § 503(c), noting "[i]f it walks like a duck (KERP) and quacks like a duck (KERP), it's a duck (KERP)."

Unlike many of the other plans which obtained court approval, the plan proposed by Dana Corporation did not have the support of the creditors' committee. Subsequently, the debtor proposed a modified plan which did have the support of the creditors' committee. This new plan included assumption of executives' pension plans, payment of lower bonus amounts that complied with restrictions in § 503(c), execution of noncompetes and payment of incentive bonuses with ceilings imposed.

Whether titled a KERP or an incentive plan, bankruptcy judges have carefully scrutinized any plan to pay bonuses to executives following the 2005 Bankruptcy Act. Where plans are genuinely designed to reward performance and result in demonstrable benefits to the creditor body, courts are more likely to grant approval. However, where plans appear to simply reward maintaining employment with the debtor, courts will typically be hesitant to bless the arrangement.

Potential Avoidance Issues
In addition to the limitations on post-petition executive compensation set forth in the 2005 Bankruptcy Act, executives have recently been the target of avoidance actions brought by trustees, creditors' committees and other parties seeking to recover bonuses, severance payments and other transfers made prior to a bankruptcy filing.

The Bankruptcy Code empowers the bankruptcy trustee or debtor-in-possession to avoid certain transfers made prior to the petition date. Section 548 of the Bankruptcy Code, among other things, allows the trustee to avoid transfers made within two years of the bankruptcy for which the debtor received less than reasonably equivalent value. Where an executive has received a large bonus or severance payment shortly before the company files for bankruptcy, legitimate questions may be raised as to whether the debtor received reasonably equivalent value for the payment.

Section 547 of the Bankruptcy Code provides another manner by which the trustee may avoid certain pre-petition transfers made on account of an antecedent debt within 90 days, and in some circumstances one year prior to the petition date. Depending upon the specific facts and circumstances, of a particular payment, transfers such as retention or annual bonuses and severance payments may be avoidable under this section. Attempts by trustees and creditors committees to avoid pre-petition payments to executives is almost certain to rise given the level of scrutiny such payments are receiving.

Post-Petition Severance
A bankruptcy filing often results in the termination of executives following the petition date. To the extent the executive is a party to an employment contract or other agreement providing for severance payments, whether those payments are entitled to administrative priority becomes paramount. Where severance payments are considered administrative claims, the executive can expect to receive full payment on his severance (in the absence of an administrative insolvency). In contrast, where severance payments are considered pre-petition claims, the executive may receive much less than was anticipated.

Courts are split on this issue, with several courts holding that severance based upon a post-petition termination is only entitled to pre-petition status. However, some courts have granted administrative expense status to such claims and the majority of courts have not considered the issue in published opinions.

Conclusion
Issues regarding executive compensation in bankruptcy cases are becoming increasingly complex. Debtors must walk the fine line between conserving estate resources and ensuring that valuable people remain with the firm during crucial periods. Bankruptcy judges have increased scrutiny of any plan or arrangement that results in increased compensation for executives. Moreover, public interest in the level of executive compensation is at an all-time high. Accordingly, both the company and the executive should consult their own counsel regarding these important issues.

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